The Recession that cannot be priced

Dear Members,

I thought this might be of interest to help you understand what is going on around you. These are figures from the US, but they answer the following questions

1. Why has the Stock Market made a recovery A. Because last Thursday the Fed Intervened to stop a collapse in stock (shares) asset value
2. Where is the downside to that? A. Two main areas, it stops us knowing the real cost of the recession, and how we are going. It distorts the market. And when the readjustment comes, it will come hard. Again Putting off Problems to buy time for survival, but at what price?
3. One gauge of that price is employment. 16 millions Americans have lost their jobs in three weeks. In the UK the Office of Budgetary Responsibility OBR is expecting Unemployment to rise from 1.5 million to 10.0 million
4. Why are SME’s being thrown to the wolves by the public sector when they will Create 65% net new Jobs? A Very Good Question. As far as I can see it is partly because they are completely out of touch with reality, and secondly because their main concern is their Jobs. I really don’t think they care, or that the people who pay their salaries are even on their radar.  We pay these people to look after us, and they look after themselves. Probably not sustainable.

Anyway, please see below for a more detailed analysis. See below for details

Exchange-traded funds (ETFs)

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The Recession That Can’t Be Priced

• The Fed delivered their most significant intervention yet, with last Thursday’s announcement that they would be buying not only investment grade fixed income ETFs, but also high yield ETFs
• This matters because:
  1. It reduces systemic risk from ETF discounts in the short term, but increases it in the long term
  2. It opens the door to the Fed keeping markets up, rather than just keeping them open
• Market pricing is distorted from reality

• 1. We are now in the recession that we won’t be able to price

Systemic Risk

• ETFs promise a liquidity mismatch between the fund and their underlying assets. This was always going to be at risk once markets came under stress.
  • Step forward the BND ETF (Vanguard’s US investment grade bond market ETF) which in early March traded at a huge 6% discount to its NAV, compared to its average closing premium of just 0.17%.
• If this had continued, investors might have rushed to liquidate before the discount got worse, locking the ETFs into a doom loop
  • Step forward the Fed on 24th March with the first announcement they would buy fixed income ETFs. That led to the biggest one-day inflows into LQD, the iShares Investment Grade Corporate Bond ETF, which ended up trading at a 5% premium to NAV
• The market is now desperate to buy up the underlying bonds as they know they can make a risk-free profit by selling the securities back to the Fed
  • The ETF arbitrage mechanism has now become a virtuous circle, with the ETF dragging up the price of the underlying bonds
• Happy Days then as credit spreads narrow, risk is eradicated, and the world looks a rosy place
  • In effect, the Fed have mandated the carry trade
• This comes straight from the 2008 playbook.
  • Back then, the price of risk was considered to be so uncertain that banks wouldn’t take any risk at all. Central Banks had to step in to provide a bid for unwanted bonds to establish a floor to the price, and guarantee risk-free profits.
• This has continued in the past decade whenever markets got too fragile
  • From Grexit to Taper Tantrum to Repo Squeeze = the central banks stepped in to set the price of risk and avert a systemic failure
• Unfortunately this behaviour increases systemic risk in the longer term
  • The breathtaking collapse of the market this year happened so quickly precisely because of the carry trade embedded into the system
  • If you encourage the world to short volatility, don’t be surprised if it blows up when real volatility shows its face

Distorted Markets

• Since the Fed’s interventions, we have returned to a long gamma world. You can see from the chart below that the sharp plunge lower in gamma (the red line) preceded the stock market collapse (blue line) – but that this has reversed course since the start of the month

• That means that we are returning to a more stable, lower volatility world
  • The delta hedging position has shifted. Instead of having to sell when the market is falling, the hedgers can sell when it’s rallying
• But wait a minute…. aren’t we now living through the worst recession of our lifetimes? All those bonds the Fed wants to buy, won’t they be impaired by huge credit losses driven by the biggest layoffs since the Great Depression? Isn’t this a hugely risky time?
• Yes. But it would be even worse if a financial crisis were to combine with the economic crisis.
  • Policymakers need the market to ignore the risk. 
• If the market were to price in a Great Depression, it would create a self-fulfilling prophecy.

This will lead to a growing disconnect between Wall Street and Main Street.

• Part of the reason the Fed have been so aggressive, so quickly, is that all of the fiscal policy help isn’t reaching people in time. With each day the economy slumbers, more jobs will be lost never to return.
• But there is only so much the Fed can do. They can buy the debt of large publicly traded companies, but that doesn’t help the Chinese takeaway, the local hairdresser, the neighbourhood plumber.
• Evidently they’ve decided it’s better to get some help out there rather than none at all: if Boeing remains a going concern then at least it retains employees who might still hire the services of all of those local people
• But half of American private sector jobs are in small businesses

• Not all of these businesses will survive the permanent impairment in the velocity of people. Even when lockdown restrictions are eased, people will think twice about eating out, going to the pub, or taking a holiday. Fear casts a long shadow.
• This will reduce the productive capacity of the economy.
  • Policymakers can try to delay it, but one day this inescapable fact will need to be priced in.
• Until then, we must all simultaneously believe everything is going to be OK, even as it’s patently obvious that things are about to become very bad indeed.

And when the day of reckoning comes for financial assets to acknowledge the real risk, it will be a sharp shock, far worse than what we have experienced so far.